HISTORY OF DERIVATIVES

The history of derivatives is surprisingly longer than what most people think. Some texts even find the existence of the characteristics of derivative contracts in incidents of Mahabharata. Traces of derivative contracts can even be found in incidents that date back to the ages before Jesus Christ. However, the advent of modern day derivative contracts is attributed to the need for farmers to protect themselves from any decline in the price of their crops due to delayed monsoon, or overproduction. The first 'futures' contracts can be traced to the Yodoya rice market in Osaka, Japan around 1650. These were evidently standardized contracts, which made them much like today's futures. The Chicago Board of Trade (CBOT), the largest derivative exchange in the world, was established in 1848 where forward contracts on various commodities were standardized around 1865. From then on, futures contracts have remained more or less in the same form, as we know them today. Derivatives have had a long presence in India. The commodity derivative market has been functioning in India since the nineteenth century with organized trading in cotton through the establishment of Cotton Trade Association in 1875. Since then contracts on various other commodities have been introduced as well. Exchange traded financial derivatives were introduced in India in June 2000 at the two major stock exchanges, NSE and BSE. There are various contracts currently traded on these exchanges. The National Stock Exchange of India Limited (NSE) commenced trading in derivatives with the launch of index futures on June 12, 2000. The futures contracts are based on the popular benchmark S&P CNX Nifty Index. The Exchange introduced trading in Index Options (also based on Nifty) on June 4, 2001. NSE also became the first exchange to launch trading in options on individual securities from July 2, 2001. Futures on individual securities were introduced on November 9, 2001. 1

Futures and Options on individual securities are available on 227 securities stipulated by SEBI. The Exchange provides trading in other indices i.e. CNX-IT, BANK NIFTY, CNX NIFTY JUNIOR, CNX 100 and NIFTY MIDCAP 50 indices. The Exchange is now introducing mini derivative (futures and options) contracts on S&P CNX Nifty index. National Commodity & Derivatives Exchange Limited (NCDEX) started its operations in December 2003, to provide a platform for commodities trading. The derivatives market in India has grown exponentially, especially at NSE. Stock Futures are the most highly traded contracts. The size of the derivatives market has become important in the last 15 years or so. In 2007 the total world derivatives market expanded to $516 trillion. With the opening of the economy to multinationals and the adoption of the liberalized economic policies, the economy is driven more towards the free market economy. The complex nature of financial structuring itself involves the utilization of multi currency transactions. It exposes the clients, particularly corporate clients to various risks such as exchange rate risk, interest rate risk, economic risk and political risk. With the integration of the financial markets and free mobility of capital, risks also multiplied. For instance, when countries adopt floating exchange rates, they have to face risks due to fluctuations in the exchange rates. Deregulation of interest rate cause interest risks. Again, securitization has brought with it the risk of default or counter party risk. Apart from it, every asset—whether commodity or metal or share or currency—is subject to depreciation in its value. It may be due to certain inherent factors and external factors like the market condition, Government’s policy, economic and political condition prevailing in the country and so on. In the present state of the economy, there is an imperative need of the corporate clients to protect there operating profits by shifting some of the uncontrollable financial risks to those who are able to bear and manage them. Thus, risk management becomes a must for survival since there is a high volatility in the present financial markets

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In this context, derivatives occupy an important place as risk reducing machinery. Derivatives are useful to reduce many of the risks discussed above. In fact, the financial service companies can play a very dynamic role in dealing with such risks. They can ensure that the above risks are hedged by using derivatives like forwards, future, options, swaps etc. Derivatives, thus, enable the clients to transfer their financial risks to the financial service companies. This really protects the clients from unforeseen risks and helps them to get there due operating profits or to keep the project well within the budget costs. To hedge the various risks that one faces in the financial market today, derivatives are absolutely essential.

INTRODUCTION TO DERIVATIVES
Derivatives are defined as financial instruments whose value derived from the prices of one or more other assets such as equity securities, fixed-income securities, foreign currencies, or commodities. Derivatives are also a kind of contract between two counterparties to exchange payments linked to the prices of underlying assets. Derivative can also be defined as a financial instrument that does not constitute ownership, but a promise to convey ownership. Examples are options and futures. The simplest example is a call option on a stock. In the case of a call option, the risk is that the person who writes the call (sells it and assumes the risk) may not be in business to live up to their promise when the time comes. In standardized options sold through the Options Clearing House, there are supposed to be sufficient safeguards for the small investor against this. The most common types of derivatives that ordinary investors are likely to come across are futures, options, warrants and convertible bonds. Beyond this, the derivatives range is only limited by the imagination of investment banks. It is likely that any person who has funds invested an insurance policy or a pension fund that they are investing in, and exposed to, derivatives-wittingly or unwittingly.

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Contracts agreement

Cash

Derivatives Others like Swaps, FRAs etc

Forward

Merchandisin g, customized

Futures (Standardized )

Options

NTSD

TSD

UNDERSTANDING DERIVATIVES
The primary objectives of any investor are to maximize returns and minimize risks.

Derivatives are contracts that originated from the need to minimize risk. The word 'derivative' originates from mathematics and refers to a variable, which has been derived from another variable. Derivatives are so called because they have no value of their own. They derive their value from the value of some other asset, which is known as the underlying. For example, a derivative of the shares of Infosys (underlying), will derive its value from the share price (value) of Infosys. Similarly, a derivative contract on soybean depends on the price of soybean. Derivatives are specialized contracts which signify an agreement or an option to buy or sell the underlying asset of the derivate up to a certain time in the future at a prearranged price, the exercise price.

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The contract also has a fixed expiry period mostly in the range of 3 to 12 months from the date of commencement of the contract. The value of the contract depends on the expiry period and also on the price of the underlying asset. For example, a farmer fears that the price of soybean (underlying), when his crop is ready for delivery will be lower than his cost of production. Let's say the cost of production is Rs 8,000 per ton. In order to overcome this uncertainty in the selling price of his crop, he enters into a contract (derivative) with a merchant, who agrees to buy the crop at a certain price (exercise price), when the crop is ready in three months time (expiry period). In this case, say the merchant agrees to buy the crop at Rs 9,000 per ton. Now, the value of this derivative contract will increase as the price of soybean decreases and vice-a-versa. If the selling price of soybean goes down to Rs 7,000 per ton, the derivative contract will be more valuable for the farmer, and if the price of soybean goes down to Rs 6,000, the contract becomes even more valuable. This is because the farmer can sell the soybean he has produced at Rs .9000 per tonne even though the market price is much less. Thus, the value of the derivative is dependent on the value of the underlying. If the underlying asset of the derivative contract is coffee, wheat, pepper, cotton, gold, silver, precious stone or for that matter even weather, then the derivative is known as a commodity derivative. If the underlying is a financial asset like debt instruments, currency, share price index, equity shares, etc, the derivative is known as a financial derivative. Derivative contracts can be standardized and traded on the stock exchange. Such derivatives are called exchange-traded derivatives. Or they can be customized as per the needs of the user by negotiating with the other party involved. Such derivatives are called over-the-counter (OTC) derivatives. Continuing with the example of the farmer above, if he thinks that the total production from his land will be 5

around 150 quintals, he can either go to a food merchant and enter into a derivatives contract to sell 150 quintals of soybean in three months time at Rs 9,000 per ton. Or the farmer can go to a commodities exchange, like the National Commodity and Derivatives Exchange Limited, and buy a standard contract on soybean. The standard contract on soybean has a size of 100 quintals. So the farmer will be left with 50 quintals of soybean uncovered for price fluctuations. However, exchange traded derivatives have some advantages like low transaction costs and no risk of default by the other party, which may exceed the cost associated with leaving a part of the production uncovered.

TYPES OF DERIVATIVES: There are mainly four types of derivatives i.e. Forwards, Futures, Options and swaps. Derivatives

Forwards

Futures

Options

Swaps

The most commonly used derivatives contracts are Forward, Futures and Options. Here some derivatives contracts that have come to be used are covered. FORWARD:-

A forward contract is a customized contract between two entities, where settlement takes place on a specific date in the future at today’s pre-agreed price. . Forwards are contracts customizable in terms of contract size, expiry date and price, as per the needs of the user.

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FUTURES:-

As the name suggests, futures are derivative contracts that give the holder the opportunity to buy or sell the underlying at a pre-specified price some time in the future. They come in standardized form with fixed expiry time, contract size and price A futures contact is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are special types of forward contracts in the sense that the former are standardized exchange-traded contracts. For example:- A, on 1 Aug. agrees to sell 600 shares of Reliance Ind. Ltd. @ Rs. 450 to B on 1st sep. FEATURE Operational Mechanism Contract FORWARD CONTRACT FUTURE CONTRACT Traded directly between two Traded on the exchanges. parties (not traded on the exchanges). Differ from trade to trade. Contracts are standardized contracts. Exists. However, assumed by the clearing corp., which becomes the counter party to all the trades or unconditionally guarantees their Liquidation Profile settlement. Low, as contracts are tailor High, as contracts are standardized exchange made contracts catering to the traded contracts. needs of the needs of the parties. Price discoveryNot efficient, as markets are Efficient, as markets are centralized and all scattered. Examples Currency market in India. buyers and sellers come to a common platform to discover the price. Commodities, futures, Index Futures and Individual stock Futures in India.

Specifications Counter-party Exists. risk

OPTIONS:-

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Options are a right available to the buyer of the same, to purchase or sell an asset, without any obligation. It means that the buyer of the option can exercise his option but is not bound to do so. Options are of 2 types: calls and puts. CALLS:Call gives the buyer the right, but not the obligation, to buy a given quantity of the underlying asset, at a given price, on or before a given future date. Example: - A, on 1 st Aug. buys an option to buy 600 shares of Reliance Ind. Ltd. @ Rs 450 on or before 1 st Sep. In this case, A has the right to buy the shares on or before the specified date, but he is not bound to buy the shares. 1. PUTS:Put gives the buyer the right, but not the obligation, to sell a given quantity of the underlying asset, at a given price, on or before a given date. For example:- A, on 1 st Aug. buys an option to sell 600 shares of Reliance Ind. Ltd. @ Rs 450 on or before 1 st Sep. In this case, A has the right to sell the shares on or before the specified date, but he is not bound to sell the shares. In both the types of the options, the seller of the option has an obligation but not a right to buy or sell an asset. His buying or selling of an asset depends upon the action of buyer of the option. His position in both the type of option is exactly the reverse of that of a buyer.

Particulars Call Options Options Put If you expect a fall in price(Bearish) Short Long If you expect a rise in price(Bullish) ong L Short  WARRANTS:-

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Options generally have lives of up to one year, the majority of options exchanges having a maximum maturity of nine months. Longer-dated options are called warrants and are generally traded over-the-counter. LEAPS:-

The acronym LEAPS means Long-Term Equity Anticipation Securities. These are options having a maturity of up to three years. BASKET:-

Basket options are options on portfolios of underlying assets are usually a moving average of a basket of assets. Equity index options are a form of basket options. SWAPS:-

Swaps are private agreement between two parties to exchange cash flows in the future according to a pre arranged formula. They can be regarded as portfolios of forward contract. The two commonly used swaps are 1. INTEREST RATE SWAPS:These entail swapping only the interest related cash flows between the parties in the same currency. 2. CURRENCY SWAPS:These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction.

SWAPTIONS:9

Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. Thus, a swaptions is an option on a forward swap. Rather than have calls and puts, the swaptions market has receiver swaptions and payer swaptions. A receiver swaptions is an option to receive fixed and pay floating. A payer swaptions is an option to pay fixed and receive floating. Out of the above mentioned types of derivatives forward, future and options are the most commonly used.

ROLE OF DERIVATIVES:
Derivative markets help investors in many different ways: RISK MANAGEMENT – Futures and options contract can be used for altering the risk of investing in spot market. For instance, consider an investor who owns an asset. He will always be worried that the price may fall before he can sell the asset. He can protect himself by selling a futures contract, or by buying a Put option. If the spot price falls, the short hedgers will gain in the futures market, as you will see later. This will help offset their losses in the spot market. Similarly, if the spot price falls below the exercise price, the put option can always be exercised. Derivatives markets help to reallocate risk among investors. A person who wants to reduce risk, can transfer some of that risk to a person who wants to take more risk. Consider a riskaverse individual. He can obviously reduce risk by hedging. When he does so, the opposite position in the market may be taken by a speculator who wishes to take more risk. Since people can alter their risk exposure using futures and options, derivatives markets help in the raising of capital. As an investor, you can always invest in an asset and then change its risk to a level that is more acceptable to you by using derivatives.

PRICE DISCOVERY – Price discovery refers to the markets ability to determine true equilibrium prices. Futures prices are believed to contain information about future spot prices and help in disseminating such information. As we have seen, futures markets provide a low cost trading mechanism. Thus information pertaining to supply and demand easily percolates into such markets. Accurate prices are essential for ensuring the correct allocation of resources in a free market 10

economy. Options markets provide information about the volatility or risk of the underlying asset.

OPERATIONAL ADVANTAGES – As opposed to spot markets, derivatives markets involve lower transaction costs. Secondly, they offer greater liquidity. Large spot transactions can often lead to significant price changes. However, futures markets tend to be more liquid than spot markets, because herein you can take large positions by depositing relatively small margins. Consequently, a large position in derivatives markets is relatively easier to take and has less of a price impact as opposed to a transaction of the same magnitude in the spot market. Finally, it is easier to take a short position in derivatives markets than it is to sell short in spot markets.

MARKET EFFICIENCY – The availability of derivatives makes markets more efficient; spot, futures and options markets are inextricably linked. Since it is easier and cheaper to trade in derivatives, it is possible to exploit arbitrage opportunities quickly and to keep prices in alignment. Hence these markets help to ensure that prices reflect true values.

EASE OF SPECULATION – Derivative markets provide speculators with a cheaper alternative to engaging in spot transactions. Also, the amount of capital required to take a comparable position is less in this case. This is important because facilitation of speculation is critical for ensuring free and fair markets. Speculators always take calculated risks. A speculator will accept a level of risk only if he is convinced that the associated expected return, is commensurate with the risk that he is taking.

DERIVATIVES MARKET IN INDIA
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DERIVATIVES IN INDIA: India has started the innovations in financial markets very late. Some of the recent developments initiated by the regulatory authorities are very important in this respect. Futures trading have been permitted in certain commodity exchanges. Mumbai Stock Exchange has started futures trading in cottonseed and cotton under the BOOE and under the East India Cotton Association. Necessary infrastructure has been created by the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE) for trading in stock index futures and the commencement of operations in selected scripts. Liberalized exchange rate management system has been introduced in the year 1992 for regulating the flow of foreign exchange. A committee headed by S.S.Tarapore was constituted to go into the merits of full convertibility on capital accounts. RBI has initiated measures for freeing the interest rate structure. It has also envisioned Mumbai Inter Bank Offer Rate (MIBOR) on the line of London Inter Bank Offer Rate (LIBOR) as a step towards introducing Futures trading in Interest Rates and Forex. Badla transactions have been banned in all 23 stock exchanges from July 2001. NSE has started trading in index options based on the NIFTY and certain Stocks. A. EQUITY DERIVATIVES IN INDIA In the decade of 1990’s revolutionary changes took place in the institutional infrastructure in India’s equity market. It has led to wholly new ideas in market design that has come to dominate the market. These new institutional arrangements, coupled with the widespread knowledge and orientation towards equity investment and speculation, have combined to provide an environment where the equity spot market is now India’s most sophisticated financial market. One aspect of the sophistication of the equity market is seen in the levels of market liquidity that are now visible. The market impact cost of doing program trades of Rs.5 million at the NIFTY index is around 0.2%. This state of liquidity on the equity spot market does well for the market efficiency, which will be observed if the index futures market when trading commences. India’s equity spot market is dominated by a new practice called ‘Futures – Style settlement’ or account period settlement. In its present scene, trades on the largest stock exchange (NSE) are netted from Wednesday morning till Tuesday evening, and only the net open position as of Tuesday evening is settled. The future style settlement has proved to be an ideal launching pad for the skills that are required for futures trading. 12

Stock trading is widely prevalent in India, hence it seems easy to think that derivatives based on individual securities could be very important. The index is the counter piece of portfolio analysis in modern financial economies. Index fluctuations affect all portfolios. The index is much harder to manipulate. This is particularly important given the weaknesses of Law Enforcement in India, which have made numerous manipulative episodes possible. The market capitalization of the NSE-50 index is Rs.2.6 trillion. This is six times larger than the market capitalization of the largest stock and 500 times larger than stocks such as Sterlite, BPL and Videocon. If market manipulation is used to artificially obtain 10% move in the price of a stock with a 10% weight in the NIFTY, this yields a 1% in the NIFTY. Cash settlements, which are universally used with index derivatives, also helps in terms of reducing the vulnerability to market manipulation, in so far as the ‘short-squeeze’ is not a problem. Thus, index derivatives are inherently less vulnerable to market manipulation. A good index is a sound trade of between diversification and liquidity. In India the traditional index- the BSE – sensitive index was created by a committee of stockbrokers in 1986. It predates a modern understanding of issues in index construction and recognition of the pivotal role of the market index in modern finance. The flows of this index and the importance of the market index in modern finance motivated the development of the NSE50 index in late 1995. Many mutual funds have now adopted the NIFTY as the benchmark for their performance evaluation efforts. If the stock derivatives have to come about, the should restricted to the most liquid stocks. Membership in the NSE-50 index appeared to be a fair test of liquidity. The 50 stocks in the NIFTY are assuredly the most liquid stocks in India. The choice of Futures vs. Options is often debated. The difference between these instruments is smaller than, commonly imagined, for a futures position is identical to an appropriately chosen long call and short put position. Hence, futures position can always be created once options exist. Individuals or firms can choose to employ positions where their downside and exposure is capped by using options. Risk management of the futures clearing is more complex when options are in the picture. When portfolios contain options, the calculation of initial price requires greater skill and more powerful computers. The skills required for pricing options are greater than those required in pricing futures. B. COMMODITY DERIVATIVES TRADING IN INDIA In India, the futures market for commodities evolved by the setting up of the “Bombay Cotton Trade Association Ltd.”, in 1875. A separate association by the name 13

"Bombay Cotton Exchange Ltd” was established following widespread discontent amongst leading cotton mill owners and merchants over the functioning of the Bombay Cotton Trade Association. With the setting up of the ‘Gujarati Vyapari Mandali” in 1900, the futures trading in oilseed began. Commodities like groundnut, castor seed and cotton etc began to be exchanged. Raw jute and jute goods began to be traded in Calcutta with the establishment of the “Calcutta Hessian Exchange Ltd.” in 1919. The most notable centres for existence of futures market for wheat were the Chamber of Commerce at Hapur, which was established in 1913. Other markets were located at Amritsar, Moga, Ludhiana, Jalandhar, Fazilka, Dhuri, Barnala and Bhatinda in Punjab and Muzaffarnagar, Chandausi, Meerut, Saharanpur, Hathras, Gaziabad, Sikenderabad and Barielly in U.P. The Bullion Futures market began in Bombay in 1990. After the economic reforms in 1991 and the trade liberalization, the Govt. of India appointed in June 1993 one more committee on Forward Markets under Chairmanship of Prof. K.N. Kabra. The Committee recommended that futures trading be introduced in basmati rice, cotton, raw jute and jute goods, groundnut, rapeseed/mustard seed, cottonseed, sesame seed, sunflower seed, safflower seed, copra and soybean, and oils and oilcakes of all of them, rice bran oil, castor oil and its oilcake, linseed, silver and onions. All over the world commodity trade forms the major backbone of the economy. In India, trading volumes in the commodity market have also seen a steady rise - to Rs 5,71,000 crore in FY05 from Rs 1,29,000 crore in FY04. In the current fiscal year, trading volumes in the commodity market have already crossed Rs 3,50,000 crore in the first four months of trading. Some of the commodities traded in India include Agricultural Commodities like Rice Wheat, Soya, Groundnut, Tea, Coffee, Jute, Rubber, Spices, Cotton, Precious Metals like Gold & Silver, Base Metals like Iron Ore, Aluminium, Nickel, Lead, Zinc and Energy Commodities like crude oil, coal. Commodities form around 50% of the Indian GDP. Though there are no institutions or banks in commodity exchanges, as yet, the market for commodities is bigger than the market for securities. Commodities market is estimated to be around Rs 44,00,000 Crores in future. Assuming a future trading multiple is about 4 times the physical market, in many countries it is much higher at around 10 times.

THE TYPES OF DERIVATIVES MARKET

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The Derivative Market can be classified as Exchange Traded Derivatives Market and Over the Counter Derivative Market. Exchange Traded Derivatives are those derivatives which are traded through specialized derivative exchanges whereas Over the Counter Derivatives are those which are privately traded between two parties and involves no exchange or intermediary. Swaps, Options and Forward Contracts are traded in Over the Counter Derivatives Market or OTC market. The main participants of OTC market are the Investment Banks, Commercial Banks, Govt. Sponsored Enterprises and Hedge Funds. The investment banks markets the derivatives through traders to the clients like hedge funds and the rest. In the Exchange Traded Derivatives Market or Future Market, exchange acts as the main party and by trading of derivatives actually risk is traded between two parties. One party who purchases future contract is said to go “long” and the person who sells the future contract is said to go “short”. The holder of the “long” position owns the future contract and earns profit from it if the price of the underlying security goes up in the future. On the contrary, holder of the “short” position is in a profitable position if the price of the underlying security goes down, as he has already sold the future contract. So, when a new future contract is introduced, the total position in the contract is zero as no one is holding that for short or long. The trading of foreign exchange traded derivatives or the future contracts has emerged as very important financial activity all over the world just like trading of equity-linked contracts or commodity contracts. The derivatives whose underlying assets are credit, energy or metal, have shown a steady growth rate over the years around the world. Interest rate is the parameter which influences the global trading of derivatives, the most.

PARTICIPANTS IN THE DERIVATIVES MARKET:
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The participants in the derivatives market are as follows: TRADING PARTICIPANTS: 1.] HEDGERS The process of managing the risk or risk management is called as hedging. Hedgers are those individuals or firms who manage their risk with the help of derivative products. Hedging does not mean maximizing of return. The main purpose for hedging is to reduce the volatility of a portfolio by reducing the risk. 2.] SPECULATORS Speculators do not have any position on which they enter into futures and options Market i.e., they take the positions in the futures market without having position in the underlying cash market. They only have a particular view about future price of a commodity, shares, stock index, interest rates or currency. They consider various factors like demand and supply, market positions, open interests, economic fundamentals, international events, etc. to make predictions. They take risk in turn from high returns. Speculators are essential in all markets – commodities, equity, interest rates and currency. They help in providing the market the much desired volume and liquidity. 3.] ARBITRAGEURS Arbitrage is the simultaneous purchase and sale of the same underlying in two different markets in an attempt to make profit from price discrepancies between the two markets. Arbitrage involves activity on several different instruments or assets simultaneously to take advantage of price distortions judged to be only temporary. Arbitrage occupies a prominent position in the futures world. It is the mechanism that keeps prices of futures contracts aligned properly with prices of underlying assets. The objective is simply to make profits without risk, but the complexity of arbitrage activity is such that it is reserved to particularly well-informed and experienced professional traders, equipped with powerful calculating and data processing tools. Arbitrage may not be as easy and costless as presumed.

INTERMEDIARY PARTICIPANTS: 16

4.] BROKERS For any purchase and sale, brokers perform an important function of bringing buyers and sellers together. As a member in any futures exchanges, may be any commodity or finance, one need not be a speculator, arbitrageur or hedger. By virtue of a member of a commodity or financial futures exchange one get a right to transact with other members of the same exchange. This transaction can be in the pit of the trading hall or on online computer terminal. All persons hedging their transaction exposures or speculating on price movement, need not be and for that matter cannot be members of futures or options exchange. A nonmember has to deal in futures exchange through member only. This provides a member the role of a broker. His existence as a broker takes the benefits of the futures and options exchange to the entire economy all transactions are done in the name of the member who is also responsible for final settlement and delivery. This activity of a member is price risk free because he is not taking any position in his account, but his other risk is clients default risk. He cannot default in his obligation to the clearing house, even if client defaults. So, this risk premium is also inbuilt in brokerage recharges. More and more involvement of nonmembers in hedging and speculation in futures and options market will increase brokerage business for member and more volume in turn reduces the brokerage. Thus more and more participation of traders other than members gives liquidity and depth to the futures and options market. Members can attract involvement of other by providing efficient services at a reasonable cost. In the absence of well functioning broking houses, the futures exchange can only function as a club. 5.] MARKET MAKERS AND JOBBERS Even in organized futures exchange, every deal cannot get the counter party immediately. It is here the jobber or market maker plays his role. They are the members of the exchange who takes the purchase or sale by other members in their books and Then Square off on the same day or the next day. They quote their bid-ask rate regularly. The difference between bid and ask is known as bid-ask spread. When volatility in price is more, the spread increases since jobbers price risk increases. In less volatile market, it is less. Generally, jobbers carry limited risk. Even by incurring loss, they square off their position as early as possible. Since they decide the market price considering the demand and supply of the commodity or asset, they are also known as market makers. Their role is more important in the exchange where outcry system of trading is present. A buyer or seller of a particular futures or option contract can approach that particular jobbing counter and quotes for 17

executing deals. In automated screen based trading best buy and sell rates are displayed on screen, so the role of jobber to some extent. In any case, jobbers provide liquidity and volume to any futures and option market. INSTITUTIONAL FRAMEWORK: 6.] EXCHANGE Exchange provides buyers and sellers of futures and option contract necessary infrastructure to trade. In outcry system, exchange has trading pit where members and their representatives assemble during a fixed trading period and execute transactions. In online trading system, exchange provide access to members and make available real time information online and also allow them to execute their orders. For derivative market to be successful exchange plays a very important role, there may be separate exchange for financial instruments and commodities or common exchange for both commodities and financial assets. 7.] CLEARING HOUSE A clearing house performs clearing of transactions executed in futures and option exchanges. Clearing house may be a separate company or it can be a division of exchange. It guarantees the performance of the contracts and for this purpose clearing house becomes counter party to each contract. Transactions are between members and clearing house. Clearing house ensures solvency of the members by putting various limits on him. Further, clearing house devises a good managing system to ensure performance of contract even in volatile market. This provides confidence of people in futures and option exchange. Therefore, it is an important institution for futures and option market. 8.] CUSTODIAN / WARE HOUSE Futures and options contracts do not generally result into delivery but there has to be smooth and standard delivery mechanism to ensure proper functioning of market. In stock index futures and options which are cash settled contracts, the issue of delivery may not arise, but it would be there in stock futures or options, commodity futures and options and interest rates futures. In the absence of proper custodian or warehouse mechanism, delivery of financial assets and commodities will be a cumbersome task and futures prices will not reflect the equilibrium price for convergence of cash price and futures price on maturity, custodian and warehouse are very relevant. 9.] BANK FOR FUND MOVEMENTS 18

Futures and options contracts are daily settled for which large fund movement from members to clearing house and back is necessary. This can be smoothly handled if a bank works in association with a clearing house. Bank can make daily accounting entries in the accounts of members and facilitate daily settlement a routine affair. This also reduces a possibility of any fraud or misappropriation of fund by any market intermediary. 10.] REGULATORY FRAMEWORK A regulator creates confidence in the market besides providing Level playing field to all concerned, for foreign exchange and money market, RBI is the regulatory authority so it can take initiative in starting futures and options trade in currency and interest rates. For capital market, SEBI is playing a lead role, along with physical market in stocks, it will also regulate the stock index futures to be started very soon in India. The approach and outlook of regulator directly affects the strength and volume in the market. For commodities, Forward Market Commission is working for settling up national National Commodity Exchange.

SCOPE OF DERIVATIVES IN INDIA

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In India, all attempts are being made to introduce derivative instruments in the capital market. The National Stock Exchange has been planning to introduce index-based futures. A stiff net worth criteria of Rs.7 to 10 corers cover is proposed for members who wish to enroll for such trading. But, it has not yet received the necessary permission from the securities and Exchange Board of India. In the forex market, there are brighter chances of introducing derivatives on a large scale. Infact, the necessary groundwork for the introduction of derivatives in forex market was prepared by a high-level expert committee appointed by the RBI. It was headed by Mr. O.P. Sodhani. Committee’s report was already submitted to the Government in 1995. As it is, a few derivative products such as interest rate swaps, coupon swaps, currency swaps and fixed rate agreements are available on a limited scale. It is easier to introduce derivatives in forex market because most of these products are OTC products (Over-the-counter) and they are highly flexible. These are always between two parties and one among them is always a financial intermediary. However, there should be proper legislations for the effective implementation of derivative contracts. The utility of derivatives through Hedging can be derived, only when, there is transparency with honest dealings. The players in the derivative market should have a sound financial base for dealing in derivative transactions. What is more important for the success of derivatives is the prescription of proper capital adequacy norms, training of financial intermediaries and the provision of well-established indices. Brokers must also be trained in the intricacies of the derivative-transactions. Now, derivatives have been introduced in the Indian Market in the form of index options and index futures. Index options and index futures are basically derivate tools based on stock index. They are really the risk management tools. Since derivates are permitted legally, one can use them to insulate his equity portfolio against the vagaries of the market. Every investor in the financial area is affected by index fluctuations. Hence, risk management using index derivatives is of far more importance than risk management using individual security options. Moreover, Portfolio risk is dominated by the market risk, regardless of the composition of the portfolio. Hence, investors would be more interested in using index-based derivative products rather than security based derivative products.

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There are no derivatives based on interest rates in India today. However, Indian users of hedging services are allowed to buy derivatives involving other currencies on foreign markets. India has a strong dollar- rupee forward market with contracts being traded for one to six month expiration. Daily trading volume on this forward market is around $500 million a day. Hence, derivatives available in India in foreign exchange area are also highly beneficial to the users

IMPACT OF DERIVATIVE MARKET ON FINANCIAL MARKETS:
Derivatives are becoming increasingly popular, so the obvious question is whether, and how, they affect the stability of financial markets. Generally, derivatives improve the overall allocation of risks within financial systems. They do so in two ways: • Derivatives make risk management more efficient and flexible especially at banks. • Derivatives allow a more efficient distribution of individual risks and a related reduction of aggregate risk within an economy. Nevertheless, a number of risk factors must be taken into account: • Poor market transparency makes it difficult at present to give an adequate assessment of risk distribution. Initiatives to gain additional market information and set appropriate reporting rules which reflect the interests of both the supervisory bodies and the market participants are therefore to be welcomed. • Risks attributable to poor contract wording (documentation risk) have already been largely overcome thanks to the steadily ongoing development of standardized rules (ISDA). • A high market concentration currently hinders the economically optimal allocation of risks, although it does not directly endanger the stability of the financial markets. But the high degree of concentration is expected to last only temporarily. • There is no clear evidence so far that credit derivatives have systematically been wrongly priced. However, this cannot be ruled out entirely at present – Especially given the inexperience of some of the participants entering the market. Systematically wrong pricing would result primarily in a misallocation of resources. • The use of derivatives may change traditional incentive structures. This is mainly a theoretical phenomenon. In practice, various mechanisms help to deal with the incentive problems which could potentially increase risk. Risks associated with the use of credit derivatives will merit special attention until

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The market has matured. Banks and financial markets will then benefit additionally from their use and become more stable. While derivatives are being used more and more in operative financial and risk management, their long-term implications for the credit and financial markets are only beginning to emerge. For the overall economy, the growing use of derivatives affects the stability of financial markets. ECONOMIC FUNCTION OF THE DERIVATIVE MARKET In spite of the fear and criticism with which the derivative markets are commonly looked at, these markets perform a number of economic functions. 1. Prices in an organized derivatives market reflect the perception of market participants about the future and lead the prices of underlying to the perceived future level. The prices of derivatives converge with the prices of the underlying at the expiration of the derivative contract. Thus derivatives help in discovery of future as well as current prices. 2. The derivatives market helps to transfer risks from those who have them but may not like them to those who have an appetite for them. 3. Derivatives, due to their inherent nature, are linked to the underlying cash markets. With the introduction of derivatives, the underlying market witnesses’ higher trade volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk. 4. Speculative trades shift to a more controlled environment of derivatives market. In the absence of an organized derivatives market, speculators trade in the underlying cash markets. Margining, monitoring and surveillance of the activities of various participants become extremely difficult in these kinds of mixed markets. 5. An important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity. The derivatives have a history of attracting many bright, creative, well-educated people with an entrepreneurial attitude. They often energize

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others to create new businesses, new products and new employment opportunities, the benefit of which are immense. In a nut shell, derivatives markets help increase savings and investment in the long run. Transfer of risk enables market participants to expand their volume of activity. According to survey conducted in India regarding the sub brokers’ opinion on the impact of derivatives market on financial market, the result obtained is given as under. Derivative securities have penetrated the Indian stock market and it emerged that investors are using these securities for different purposes, namely, risk management, profit enhancement, speculation and arbitrage. High net worth individuals and proprietary traders account for a large proportion of broker turnover. Interestingly, some retail participation was also witnessed despite the fact that these securities are considered largely beyond the reach of retail investors (because of complexity and relatively high initial investment). Based on the survey results, the authors identified some important policy issues such as the need to bring in more institutional participation to make the derivative market in India more efficient and to bring it in line with the best practices. Further, there is a need to popularize option instruments because they may prove to be a useful medium for enhancing retail participation in the derivative market.

THE NEED OF DERIVATIVES MARKET:
The derivatives market performs a number of economic functions: 1. They help in transferring risks from risk adverse people to risk oriented people 2. They help in the discovery of future as well as current prices 3. They catalyze entrepreneurial activity 4. They increase the volume traded in markets because of participation of risk adverse people in greater numbers 5. They increase savings and investment in the long run

SCENARIO OF DERIVATIVES MARKET IN INDIA
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The emergence of the market for derivatives products, most notable forwards, futures, options and swaps can be traced back to the willingness of risk-averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices. By their very nature, the financial markets can be subject to a very high degree of volatility. Through the use of derivative products, it is possible to partially or fully transfer price risks by locking-in asset prices. As instruments of risk management, derivatives products generally do not influence the fluctuations in the underlying asset prices. However, by locking-in asset prices, derivatives products minimize the impact of fluctuations in asset prices on the profitability and cash flow situation of risk-averse investors. Starting from a controlled economy, India has moved towards a world where prices fluctuate every day. The introduction of risk management instruments in India gained momentum in the last few years due to liberalization process and Reserve Bank of India’s (RBI) efforts in creating currency forward market. Derivatives are an integral part of liberalization process to manage risk. NSE gauging the market requirements initiated the process of setting up derivative markets in India. In July 1999, derivatives trading commenced in India Chronology of instruments 1991 Liberalization process initiated 14 December 1995 SE asked SEBI for permission to trade index futures. N 18 November 1996EBI setup L.C.Gupta Committee to draft a policy framework for index S 11 May 1998 7 July 1999 24 May 2000 25 May 2000 9 June 2000 12 June 2000 25,September 2000 2 June 2001 futures. L.C.Gupta Committee submitted report. RBI gave permission for OTC forward rate agreements (FRAs) and interest rate swaps. SIMEX chose Nifty for trading futures and options on an Indian index. SEBI gave permission to NSE and BSE to do index futures trading. Trading of BSE Sensex futures commenced at BSE. Trading of Nifty futures commenced at NSE. Nifty futures trading commenced at SGX. Individual Stock Options & Derivatives

FACTORS CONTRIBUTING TO THE GROWTH OF DERIVATIVES:
Factors contributing to the explosive growth of derivatives are price volatility, globalization of the markets, technological developments and advances in the financial theories. A. PRICE VOLATILITY 24

A price is what one pays to acquire or use something of value. The objects having value maybe commodities, local currency or foreign currencies. The concept of price is clear to almost everybody when we discuss commodities. There is a price to be paid for the purchase of food grain, oil, petrol, metal, etc. the price one pays for use of a unit of another persons money is called interest rate. And the price one pays in one’s own currency for a unit of another currency is called as an exchange rate. Prices are generally determined by market forces. In a market, consumers have ‘demand’ and producers or suppliers have ‘supply’, and the collective interaction of demand and supply in the market determines the price. These factors are constantly interacting in the market causing changes in the price over a short period of time. Such changes in the price are known as ‘price volatility’. This has three factors: the speed of price changes, the frequency of price changes and the magnitude of price changes. The changes in demand and supply influencing factors culminate in market adjustments through price changes. These price changes expose individuals, producing firms and governments to significant risks. The break down of the BRETTON WOODS agreement brought and end to the stabilizing role of fixed exchange rates and the gold convertibility of the dollars. The globalization of the markets and rapid industrialization of many underdeveloped countries brought a new scale and dimension to the markets. Nations that were poor suddenly became a major source of supply of goods. The Mexican crisis in the south east-Asian currency crisis of 1990’s has also brought the price volatility factor on the surface. The advent of telecommunication and data processing bought information very quickly to the markets. Information which would have taken months to impact the market earlier can now be obtained in matter of moments. Even equity holders are exposed to price risk of corporate share fluctuates rapidly. This price volatility risk pushed the use of derivatives like futures and options increasingly as these instruments can be used as hedge to protect against adverse price changes in commodity, foreign exchange, equity shares and bonds. B. GLOBALISATION OF MARKETS – Earlier, managers had to deal with domestic economic concerns; what happened in other part of the world was mostly irrelevant. Now globalization has increased the size of markets and as greatly enhanced competition .it has benefited consumers who cannot obtain better

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quality goods at a lower cost. It has also exposed the modern business to significant risks and, in many cases, led to cut profit margins In Indian context, south East Asian currencies crisis of 1997 had affected the competitiveness of our products vis-à-vis depreciated currencies. Export of certain goods from India declined because of this crisis. Steel industry in 1998 suffered its worst set back due to cheap import of steel from south East Asian countries. Suddenly blue chip companies had turned in to red. The fear of china devaluing its currency created instability in Indian exports. Thus, it is evident that globalization of industrial and financial activities necessitates use of derivatives to guard against future losses. This factor alone has contributed to the growth of derivatives to a significant extent. C. TECHNOLOGICAL ADVANCES – A significant growth of derivative instruments has been driven by technological break through. Advances in this area include the development of high speed processors, network systems and enhanced method of data entry. Closely related to advances in computer technology are advances in telecommunications. Improvement in communications allow for instantaneous world wide conferencing, Data transmission by satellite. At the same time there were significant advances in software programmed without which computer and telecommunication advances would be meaningless. These facilitated the more rapid movement of information and consequently its instantaneous impact on market price. Although price sensitivity to market forces is beneficial to the economy as a whole resources are rapidly relocated to more productive use and better rationed overtime the greater price volatility exposes producers and consumers to greater price risk. The effect of this risk can easily destroy a business which is otherwise well managed. Derivatives can help a firm manage the price risk inherent in a market economy. To the extent the technological developments increase volatility, derivatives and risk management products become that much more important. D. ADVANCES IN FINANCIAL THEORIES – Advances in financial theories gave birth to derivatives. Initially forward contracts in its traditional form, was the only hedging tool available. Option pricing models developed by Black and Scholes in 1973 were used to determine prices of call and put options. In late 1970’s, work of Lewis Edeington extended the early work of Johnson and started the 26

hedging of financial price risks with financial futures. The work of economic theorists gave rise to new products for risk management which led to the growth of derivatives in financial markets. The above factors in combination of lot many factors led to growth of derivatives instruments.

THE TREND OF DERIVATIVE MARKET IN INDIA
Derivative products made a debut in the Indian market during 1998 and overall progress of derivatives market in India has indeed been impressive. The Indian equity derivatives market has registered an "explosive growth" and is expected to continue its dream run in the years to come with the various pieces that are crucial for the market's growth slowly falling in place. Over the counter derivatives market in Interest Rate and Foreign Exchange has also witnessed impressive growth with RBI allowing the local banks to run books in Indian Rupee Interest Rate and FX derivatives. The complexity of market continues to increase as clients have become savvier, demanding more fine tuned solution to meet their risk management objectives, rather than using the vanilla products. Besides Rupee derivatives offered by the local players, RBI has also allowed the client to use more exotic products like barrier options. These products are offered by the local bank on back-to-back basis, wherein they buy similar product from market maker from the offshore markets. The complexity of derivatives market has increased, but the growth in deployment of risk management systems required to manage such complex business has not grown at the same pace. The reason being, the very high cost of such system and absence of any local player who could offer the solution, which could compete with product offered by the international vendors.

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DERIVATIVES MARKET GROWTH The Derivatives Market Growth was about 30% in the first half of 2007 when it reached a size of $US 370 trillion. This growth was mainly due to the increase in the participation of the bankers, investors and different companies. The derivative market instruments are used by them to hedge risks as well as to satisfy their speculative needs.

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The derivative market growth for different derivative market instruments may be discussed under the following heads. • Derivative Market Growth for the Exchange-traded-Derivatives The Derivative Market Growth for equity reached $114.1 trillion. The open interest in the futures and options market grew by 38 % while the interest rate futures grew by 42%. Hence the derivative market size for the futures and the options market was $49 trillion. • Derivative Market Growth for the Global Over-the-Counter Derivatives The contracts traded through Over-the-Counter market witnessed a 24 % increase in its face value and the over-the -counter derivative market size reached $70,000 billion. This shows that the face value of the derivative contracts has multiplied 30 times the size of the US economy. Notable increases were recorded for foreign exchange, interest rate, equity and commodity based derivative following an increase in the size of the Over-the Counter derivative market. The Derivative Market Growth does not necessitate an increase in the risk taken by the different investors. Even then, the overshoot in the face value of the derivative contracts shows that these derivative instruments played a pivotal role in the financial market of today. • Derivative Market Growth for the Credit Derivatives The credit derivatives grew from $4.5 trillion to $0.7 trillion in 2001. This derivative market growth is attributed to the increase in the trading in the synthetic collateral Debt obligations and also to the electronic trading systems that have come into existence. The Bank of International Settlements measures the size and the growth of the derivative market. According to BIS, the derivative market growth in the over the counter derivative market witnessed a slump in the second half of 2006. Although the credit derivative market grew at a rapid pace, such growth was made offset by a slump somewhere else. The notional amount of the Credit Default Swap witnessed a growth of 42%. Credit derivatives grew by 54%. The single name contracts grew by 36%. The interest derivatives grew by 11%. The

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OTC foreign exchange derivatives slowed by 5%, the OTC equity derivatives slowed by 10%. Commodity derivatives also experienced crawling growth pattern. Business Growth in Derivatives segment
Year Index Futures Stock Futures Index Options Stock Options

No. of contracts

Turnover No. of (Rs. cr.) contracts

Turnover (Rs. cr.)

No. of contracts

Notional Turnover (Rs. cr.)

No. of contracts

Notional Turnover (Rs. cr.)

2009-10 2008-09 2007-08 2006-07 2005-06 2004-05 2003-04 2002-03 2001-02 2000-01

86651879 210428103 156598579 81487424 58537886 21635449 17191668 2126763 1025588 90580

1715349.01 3570111.40 3820667.27 2539574 1513755 772147 554446 43952 21483 2365

59128122 221577980 203587952 104955401 80905493 47043066 32368842 10676843 1957856

2257189.61 3479642.12 7548563.23 3830967 2791697 1484056 1305939 286533 51515

132889753 212088444 55366038 25157438 12935116 3293558 1732414 442241 175900

2789950.24 3731501.84 1362110.88 791906 338469 121943 52816 9246 3765

4731748 13295970 9460631 5283310 5240776 5045112 5583071 3523062 1037529

187261.34 229226.81 359136.55 193795 180253 168836 217207 100131 25163

TURNOVER OF CASH MARKET AFTER DERIVATIVES INTRODUCED:

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TURNOVER OF CASH MARKET BEFORE DERIVATIVES INTRODUCED: YEAR 2009-10 (upto 31st Aug.) 2008-2009 2007-2008 2006-2007 2005-2006 2004-2005 2003-2004 2002-2003 2001-2002 YEAR 2000-2001 1999-2000 1998-1999 1997-1998 1996-1997 1995-1996 1994-1995 BSE Turnover(Rs. Cr,) (F.Y. Jan-Dec) 587901 1586441.49 1160248.63 701709.67 547922.44 365613.61 409372.67 332909.01 475278.79 NSE Turnover(Rs. Cr.) (F.Y. Apr-Mar) 1922783 2,752,023 3,551,038 1,945,285 1,569,556 1,140,071 1,099,535 617,989 513,167

BSE Turnover(Rs. Cr,)(F.Y. NSE Turnover (Rs. Cr.)(F.Y. Jan-Dec) Apr-Mar) 998655.28 1,339,510 527960.16 839,052 414,474 370,193 294,503 67,287 1,805

(SOURCES: NSE and BSE, http:// nseindia.com/ Home > F&O > Market Information > Historical Data > Business Growth in Derivatives segment and http://nseindia.com/Home > Equities > Market Information > Historical Data > Business Growth in CM Segment http://www.bseindia.com/about/st_key/volumeofturnoverbusiness_tran_05.asp)

MYTHS AND REALITIES ABOUT DERIVATIVES

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In less than three decades of their coming into vogue, derivatives markets have become the most important markets in the world. Financial derivatives came into the spotlight along with the rise in uncertainty of post-1970, when US announced an end to the Bretton Woods System of fixed exchange rates leading to introduction of currency derivatives followed by other innovations including stock index futures. Today, derivatives have become part and parcel of the day-to-day life for ordinary people in major parts of the world. While this is true for many countries, there are still apprehensions about the introduction of derivatives. There are many myths about derivatives but the realities that are different especially for Exchange traded derivatives, which are well regulated with all the safety mechanisms in place. What are these myths behind derivatives? • • • • Derivatives increase speculation and do not serve any economic purpose Indian Market is not ready for derivative trading Disasters prove that derivatives are very risky and highly leveraged instruments Derivatives are complex and exotic instruments that Indian investors will find

difficulty in understanding • Is the existing capital market safer than Derivatives? 1. Derivatives increase speculation and do not serve any economic purpose While the fact is... Numerous studies of derivatives activity have led to a broad consensus, both in the private and public sectors that derivatives provide numerous and substantial benefits to the users. Derivatives are a low-cost, effective method for users to hedge and manage their exposures to interest rates, commodity prices, or exchange rates. The need for derivatives as hedging tool was felt first in the commodities market. Agricultural futures and options helped farmers and processors hedge against commodity price risk. After the fallout of Bretton wood agreement, the financial markets in the world started undergoing radical changes. This period is marked by remarkable innovations in the financial markets such as introduction of floating rates for the currencies, increased trading in variety of derivatives instruments, on-line trading in the capital markets, etc. As the complexity of instruments increased many folds, the accompanying risk factors grew in 32

gigantic proportions. This situation led to development derivatives as effective risk management tools for the market participants. Looking at the equity market, derivatives allow corporations and institutional investors to effectively manage their portfolios of assets and liabilities through instruments like stock index futures and options. An equity fund, for example, can reduce its exposure to the stock market quickly and at a relatively low cost without selling off part of its equity assets by using stock index futures or index options. By providing investors and issuers with a wider array of tools for managing risks and raising capital, derivatives improve the allocation of credit and the sharing of risk in the global economy, lowering the cost of capital formation and stimulating economic growth. Now that world markets for trade and finance have become more integrated, derivatives have strengthened these important linkages between global markets, increasing market liquidity and efficiency and facilitating the flow of trade and finance. 2. Indian Market is not ready for derivative trading While the fact is... Often the argument put forth against derivatives trading is that the Indian capital market is not ready for derivatives trading. Here, we look into the pre-requisites, which are needed for the introduction of derivatives and how Indian market fares: PRE-REQUISITES Large market Capitalization INDIAN SCENARIO India is one of the largest market-capitalized countries in Asia with a market capitalization of more than Rs.765000 crores. High Liquidity in the underlying daily average traded volume in Indian capital The market today is around 7500 crores. Which means on an average every month 14% of the country’s Market capitalisation gets traded. These are clear indicators of high liquidity in the underlying.

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Trade guarantee

The first clearing corporation guaranteeing trades has become fully functional from July 1996 in the form of National Securities Clearing Corporation (NSCCL). NSCCL is responsible for guaranteeing all open positions on the National Stock Exchange (NSE) for which it does the clearing.

A Strong Depository

National Securities Depositories Limited (NSDL) which started functioning in the year 1997 has revolutionalised the security settlement in our country.

A Good legal guardian

In the Institution of SEBI (Securities and Exchange Board of India) today the Indian capital market enjoys a strong, independent, and innovative legal guardian who is helping the market to evolve to a healthier place for trade practices.

3. Disasters prove that derivatives are very risky and highly leveraged instruments While the fact is... Disasters can take place in any system. The 1992 Security scam is a case in point. Disasters are not necessarily due to dealing in derivatives, but derivatives make headlines... Here I have tried to explain some of the important issues involved in disasters related to derivatives. Careful observation will tell us that these disasters have occurred due to lack of internal controls and/or outright fraud either by the employees or promoters.

Barings Collapse 1. 2. 3. 4. 233 year old British bank goes bankrupt on 26th February 1995 Downfall attributed to a single trader, 28 year old Nicholas Leeson Loss arose due to large exposure to the Japanese futures market Leeson, chief trader for Barings futures in Singapore, takes huge position in index

futures of Nikkei 225 34

5. 6. 7.

Market falls by more than 15% in the first two months of ’95 and Barings suffers Bank looses $1.3 billion from derivative trading Loss wipes out the entire equity capital of Barings

huge losses

The reasons for the collapse: • • • Leeson was supposed to be arbitraging between Osaka Securities Exchange and SIMEX Leeson was heading both settlement and trading desk -- at most other banks the Lack of independent risk management unit, again a deviation from prudential norms.

-- a risk less strategy, while in truth it was an unhedged position. functions are segregated, this helped Leeson to cover his losses -- Leeson was unsupervised. There were no proper internal control mechanisms leading to the discrepancies going unnoticed – Internal audit report which warned of "excessive concentration of power in Leeson’s hands" was ignored by the top management. The conclusion as summarised by Wall Street Journal article " Bank of England officials said they did not regard the problem in this case as one peculiar to derivatives. In a case where a trader is taking unauthorised positions, they said, the real question is the strength of an investment houses’ internal controls and the external monitoring done by Exchanges and Regulators. " 1. Metallgesellshaft (MG) -- a hedge that went bad to the tune of $1.3 billion

Germany’s 14th largest industrial group nearly goes bankrupt from losses suffered through its American subsidiary - MGRM 2. 3. 4. 5. MGRM offered long term contracts to supply 180 million barrels of oil products to MGRM created a hedge position for these long term contracts with short term futures Company was exposed to basis risk -- risk of short term oil prices temporarily In 1993, oil prices crashed, leading to billion dollars of margin call to be met in cash. its clients -- commitments were quite large, equivalent to 85 days of Kuwait’s oil output market through rolling hedge --, As there was no viable long term contracts available deviating from long term prices. The Company was faced with temporary funds crunch.

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6. 7.

New management team decides to liquidate the remaining contracts, leading to a loss Liquidation has been criticized, as the losses could have decreased over time.

of 1.3 billion. Auditors’ report claims that the losses were caused by the size of the trading exposure. Reasons for the losses: • • • • • The transactions carried out by the company were mainly OTC in nature and hence Large exposure Temporary funds crunch Lack of matching long-term contracts, which necessitated the company to use rolling Basis risk leading to short term loss lacked transparency and risk management system employed by a derivative exchange

short term hedge -- problem arising from the hedging strategy

4. Derivatives are complex and exotic instruments that Indian investors will have difficulty in understanding While the fact is... Trading in standard derivatives such as forwards, futures and options is already prevalent in India and has a long history. Reserve Bank of India allows forward trading in Rupee-Dollar forward contracts, which has become a liquid market. Reserve Bank of India also allows Cross Currency options trading. Forward Markets Commission has allowed trading in Commodity Forwards on Commodities Exchanges, which are, called Futures in international markets. Commodities futures in India are available in turmeric, black pepper, coffee, Gur (jaggery), hessian, castor seed oil etc. There are plans to set up commodities futures exchanges in Soya bean oil as also in Cotton. International markets have also been allowed (dollar denominated contracts) in certain commodities. Reserve Bank of India also allows, the users to hedge their portfolios through derivatives exchanges abroad. Detailed guidelines have been prescribed by the RBI for the purpose of getting approvals to hedge the user’s exposure in international markets. 36

Derivatives in commodities markets have a long history. The first commodity futures exchange was set up in 1875 in Mumbai under the aegis of Bombay Cotton Traders Association (Dr.A.S.Naik, 1968, Chairman, Forwards Markets Commission, India, 196368). A clearinghouse for clearing and settlement of these trades was set up in 1918. In oilseeds, a futures market was established in 1900. Wheat futures market began in Hapur in 1913. Futures market in raw jute was set up in Calcutta in 1912. Bullion futures market was set up in Mumbai in 1920. History and existence of markets along with setting up of new markets prove that the concept of derivatives is not alien to India. In commodity markets, there is no resistance from the users or market participants to trade in commodity futures or foreign exchange markets. Government of India has also been facilitating the setting up and operations of these markets in India by providing approvals and defining appropriate regulatory frameworks for their operations. Approval for new exchanges in last six months by the Government of India also indicates that Government of India does not consider this type of trading to be harmful albeit within proper regulatory framework. This amply proves that the concept of options and futures has been well ingrained in the Indian equities market for a long time and is not alien as it is made out to be. Even today, complex strategies of options are being traded in many exchanges which are called tejimandi, jota-phatak, bhav-bhav at different places in India (Vohra and Bagari,1998) In that sense, the derivatives are not new to India and are also currently prevalent in various markets including equities markets.

5. Is the existing capital market safer than Derivatives? While the fact is... World over, the spot markets in equities are operated on a principle of rolling settlement. In this kind of trading, if you trade on a particular day (T), you have to settle these trades on the third working day from the date of trading (T+3).

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Futures market allow you to trade for a period of say 1 month or 3 months and allow you to net the transaction taken place during the period for the settlement at the end of the period. In India, most of the stock exchanges allow the participants to trade during one-week period for settlement in the following week. The trades are netted for the settlement for the entire one-week period. In that sense, the Indian markets are already operating the futures style settlement rather than cash markets prevalent internationally. In this system, additionally, many exchanges also allow the forward trading called badla in Gujarati and Contango in English, which was prevalent in UK. This system is prevalent currently in France in their monthly settlement markets. It allowed one to even further increase the time to settle for almost 3 months under the earlier regulations. This way, a curious mix of futures style settlement with facility to carry the settlement obligations forward creates discrepancies. The more efficient way from the regulatory perspective will be to separate out the derivatives from the cash market i.e. introduce rolling settlement in all exchanges and at the same time allow futures and options to trade. This way, the regulators will also be able to regulate both the markets easily and it will provide more flexibility to the market participants. In addition, the existing system although futures style, does not ask for any margins from the clients. Given the volatility of the equities market in India, this system has become quite prone to systemic collapse. This was evident in the MS Shoes scandal. At the time of default taking place on the BSE, the defaulting member of the BSE Mr.Zaveri had a position close to Rs.18 crores. However, due to the default, BSE had to stop trading for a period of three days. At the same time, the Barings Bank failed on Singapore Monetary Exchange (SIMEX) for the exposure of more than US $ 20 billion (more than Rs.84,000 crore) with a loss of approximately US $ 900 million ( around Rs.3,800 crore). Although, the exposure was so high and even the loss was also very big compared to the total exposure on MS Shoes for BSE of Rs.18 crores, the SIMEX had taken so much margins that they did not stop trading for a single minute. 6. Comparison of New System with Existing System

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Many people and brokers in India think that the new system of Futures & Options and banning of Badla is disadvantageous and introduced early, but I feel that this new system is very useful especially to retail investors. It increases the no of options investors for investment. In fact it should have been introduced much before and NSE had approved it but was not active because of politicization in SEBI

THE NEW ERA OF DERIVATIVES
Different types of derivatives available for use by these institutional investors in India: Equity, Foreign Currency, and Commodity Derivatives. The intensity of derivatives usage by any institutional investor is a function of its ability and willingness to use derivatives for one or more of the following purposes: 39

1. Risk Containment: Using derivatives for hedging and risk containment purposes. 2. Risk Trading/Market Making: Running derivatives trading book for profits and arbitrage. The different institutional investors could be meaningfully classified into: Banks, All India Financial Institutions (FIs), Mutual Funds (MFs), Foreign Institutional Investors (FIIs) and Life and General Insurers. 1. Banks Based on the differences in governance structure, business practices and organizational ethos, it is meaningful to classify the Indian banking sector into the following: 1. Public Sector Banks (PSBs); 2. Private Sector Banks (Old Generation); 3. Private Sector Banks (New Generation); and 4. Foreign Banks (with banking and authorized dealer license). • Foreign Currency Derivatives Of Banks

Banks that are Authorized Dealers (ADs) under the exchange control law are permitted by RBI to undertake the following foreign currency (FCY) derivative transactions: For bank customers for hedging their FCY risks. – FCY: INR Forward Contracts, and Swaps – Cross-Currency Forward Contracts and Swaps. – Cross-Currency Options. There is now an active Over-The-Counter (OTC) foreign currency derivatives market in India. However, the activity of most PSB majors in this market is limited to writing FCY derivatives contracts with their corporate customers on fully covered back-to-back basis. And, most PSBs do not run an active foreign currency derivative trading book, on account of the impediments enumerated earlier that need to be overcome at their end.

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2. All India financial institutions (FIs) With the merger of ICICI into ICICI Bank, the universe of all-India FIs comprises IDBI, IFCI, IIBI, SIDBI, EXIM, NABARD and IDFC. In the context of use of financial derivatives, the universe of FIs could perhaps be extended to include a few other financially significant players such as HDFC and NHB. • Foreign Currency Derivatives Of FIs

Most FIs with foreign currency borrowings have been users of FCY:INR swaps, cross currency swaps, CC-IRS, and FRAs for their liabilities management. With the prior approval of RBI, FIs can also offer foreign currency derivatives as a product to their corporate borrowers on a fully “covered” back-to-back basis. Yet, most FIs have not yet readied themselves to explore this business opportunity. 3. Mutual funds • Foreign currency derivatives

In September 1999, 9 Indian mutual funds were allowed to invest in ADRs/GDRs of Indian companies in the overseas market within the overall limit of US$ 500 million with a subceiling for individual mutual funds of 10 percent of net assets managed by them (at previous year-end), subject to maximum of US$ 50 million per mutual fund. Several mutual funds had obtained the requisite approvals from SEBI and RBI for making such investments. However, given that most ADRs/GDRs of Indian companies traded in the overseas market at a premium to their prices on domestic equity markets, this facility has remained largely unutilized. Therefore, the question of using FCY: INR forward cover or swap did not much arise. However, recently, from 30 March 2002, 10 domestic mutual funds have been permitted to invest in foreign sovereign and corporate debt securities (AAA rated by S&P or Moody or Fitch IBCA) in countries with fully convertible currencies within the overall market limit of US$ 500 million, with a sub-ceiling for individual mutual funds of four percent of net assets managed by them as on 28 February 2002, subject to a maximum of US$ 50 million per mutual fund. Several mutual funds have now obtained the requisite SEBI and RBI approvals for making these investments. Once investment in foreign debt securities pick-up, mutual funds ought to 41

emerge as active users of FCY: INR swaps to hedge the foreign currency risk in these investments. 4. Life and general insurance • Foreign currency derivatives

Given the long-term nature of life insurance contracts, insurance regulations in many parts of the world apply currency-matching principle for assets and liabilities under life insurance contracts. Indian insurance law too prohibits investment of funds from insurance business written in India, into overseas or foreign securities. Hence, Indian life and general insurers have no presence in the foreign currency derivatives market in India

RECENT DEVELOPMENTS
At present Derivative Trading has been permitted by the SEBI on derivative segment of the BSE and the F&0 segment of the NSE. The natures of derivative contracts permitted are: The minimum contract size of a derivative contract is Rs.2 lakhs. Besides the minimum contract size, there is a stipulation for the lot size of a derivative contract. The lot size refers to number of underlying securities in one contract. The lot size of the underlying individual 42

security should be in multiples of 100 and tractions, if any should be rounded of to next higher multiple of 100. Apart from the above, there are market wide limits also. The market wide limit for index products in NIL. For stock specific products it is of open positions. But, for option and futures the following wide limits have been fixed. Ø 30 times the average number of shares traded daily, during the previous calendar month in the cash segment of the exchange. Or Ø 10% of the number of shares held by non-promoters, i.e., 10% of the free float in terms of number of shares of a company. BSE to launch mini contracts in derivative market: To attract retail investors into the ever growing derivatives market, the Bombay Stock Exchange will launch ' Sensex mini derivatives contracts' from January 1, 2009. The small size of the contract would woo retail investors as there would be comparatively lower capital outlay, trading costs, more precise hedging and flexible trading, a BSE release said. The mini derivatives contracts would be in a market lot of five, it added. It is a step to encourage and enable small investors to mitigate risk and gain easy access to India's popular index, Sensex, through futures and options, the release said. The security symbol for Sensex mini contracts would be MSX and would be available for one, two and three months along with weekly options. Market watchdog SEBI has approved introduction of seven new derivative products for the domestic market. "The introduction of these products is a step intended to progressively encourage markets to move onshore," SEBI had said. The Securities and Exchange Board of India had allowed trading in mini contracts on index (BSE 30-share Sensex and NSE 50-share Nifty) with a minimum contract size of Rs 1 lakh. 43

Derivatives’ Contract Size To Be Halved: The ministry of finance (FinMin) has decided, in principle, to halve the contract size for derivatives trading from the current Rs 2 lakh per contract to Rs 1 lakh. The FinMin is expected to consult with the law ministry on the issue before formally announcing the decision. The Securities and Exchange Board of India (Sebi) will decide when to introduce the reduced contracts. This was revealed by UK Sinha, joint secretary, FinMin, on the sidelines of a seminar, ‘Convention on Capital Markets’, which was jointly organised by Sebi and the Federation of Indian Chambers of Commerce and Industry (Ficci) in Mumbai on Wednesday. Mr Sinha said, “The ministry has approved the proposal to halve the contract size and Sebi will take the final decision on when to introduce contracts of the reduced size.” The issue of higher contract size in derivatives trading was proving to be an impediment in increasing retail investors’ participation. The higher contract size of Rs 2 lakh was recommended by the standing committee on finance, comprising members of Parliament (MPs). Sebi and other market participants have written to MoF to intervene on this issue and suggest amendments to the recommendation. The contract size suggested by the standing committee was not only high but was acting as roadblock, particularly in rising markets as the number of shares to be bought in a contract was fixed when the markets were trading at a very lower level. But now when the markets have risen, investors wishing to go in for derivatives markets have to take positions based on the number of shares fixed at lower prices, which made the going tough for the smaller investors. Meanwhile, Sebi has clarified that it does not have the agenda of checking any rally on the bourses but will continue to focus on checking the market integrity. However, Sebi chairman GN Bajpai said, “We have put our surveillance system in a state of “high alert” to detect any 44

“misconduct” and protect investors’ interest. We are watching developments to see if there are any unusual movements in the market which are not based on fundamentals.” The general market perception, however, is that the regulator is trying to spoke the rally witnessed in the stock markets. Mr Bajpai said Sebi’s concern about rising market is valid and the regulator has to be cautious as the market was coming out from a prolonged spate of corporate misconducts throughout the world, including India. Development towards SWAPS: At present, swaps are the only types of rupee derivatives which can be traded in India. Banks cannot trade in or offer options on Rupee interest rates, either stand−alone or embedded in swaps. There are three main categories of products, which in turn have different benchmarks on which these are transacted. 1. Plain Vanilla Interest Rate Swaps: These are the most basic and actively traded instruments in the market. The underlying benchmark in these swaps is linked to funding costs for banks or corporate. The principal benchmarks are: · Overnight Index Swaps (OIS): This is the most popular and liquid benchmark, especially in the Interbank market, with a total volume of almost Rs 70,000 Crores being transacted in 2001−02. This was the first benchmark that was actively used by banks, since it fulfilled a long felt need for them to be able to extend the duration and manage the volatility of their overnight borrowings. As the name implies, the underlying benchmark is the overnight call money rate. The floating benchmark is known as MIBOR, which is a daily fixing done by the National Stock Exchange (NSE) against which the swap is settled. Although the floating rate is reset daily, for the sake of convenience, it is compounded and settled only at a frequency which 45

can be chosen by the swap counter parties (for eg, every month, quarter or half year). Although OIS swaps are quoted out to five years, the maximum liquidity is for tenor’s up to two years. · MITOR Swaps: These are similar to OIS swaps, with the difference being that the underlying overnight floating rupee rate is derived from the USD Fed Funds Rate and the USD/INR C/T Premia, rather than being directly derived from the actual call rate in the Indian market. This benchmark is not as popular as the preceding OIS benchmark. · MIFOR: This is another popular benchmark that has developed into a proxy for the AAA corporate funding cost in India. Since India does not have a fully developed term money market, it is derived from USD Libor and the USD/INR Forward Premia, both of which are extremely deep and liquid markets. Although the popular perception is that MIFOR might be subject to sudden swings on account of the fact that it is derived from the forex forwards market, this is a misplaced fear − it is simply the Indian equivalent of USD Libor and the USD Interest Rate Swaps market, and behaves like an interest rate benchmark, not a forex benchmark. There are a large number of Indian Corporates who now regularly use this benchmark to actively manage the interest rate risk on their debt portfolios, and access funding at better rates. 2. Currency Swaps: These are interest rate derivatives whereby Rupee debt held by banks or corporates can be swapped into debt in another currency or vice versa. As expected, the most popular currency for swapping debt is the US Dollar, with the Japanese Yen coming in second. It is especially useful for companies having raised forex debt who wish to hedge all or part of the foreign exchange risk and interest rate risk by swapping into Rupees. Similarly, companies holding rupee debt who wish to either lower funding costs or diversify the currency mix of their debt portfolios often choose to swap from rupee debt into forex debt.

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An interesting point to note is that while no optionality is permitted on the Rupee leg of the currency swap, there is substantial scope for employing more sophisticated hedging strategies by embedding options on the forex leg of the swap. There are also many variants of currency swaps, like coupon swaps and Principal Only swaps (POS) which are popular amongst Indian corporate. . 3. G−Sec Linked Swaps: While the first category of benchmarks like OIS and MIFOR are linked to corporate/bank funding costs in India, this category of benchmarks is linked to the Government of India’s borrowing cost, viz. yields on Government Securities (G−Sec). Just as a company can enter into a swap where the benchmark for the floating leg is 6 month MIFOR, it can also enter into a swap where the benchmark is the yield on the 1−Year G−Sec. The daily setting for G−Sec yields for different tenors is exhibited on a Reuter’s page known as INBMK. These swaps are important as they allow banks and corporate to take views on the relative movements of GOI yields and corporate spreads, without necessarily actually taking positions in the securities themselves. Apart from these basic products, there are a variety of complex products that can be built from these underlying benchmarks. For e.g., a popular variant in India has been the Constant Maturity Treasury (CMT) swap, where the underlying floating rate, instead of being a 3−month or 6−month rate, is the 5− Year G−Sec Yield. There are also forward rate agreements, rate locks, spread locks, quanto swaps etc which all use these basic building blocks to allow the swap counter parties to take more sophisticated views on not only the future movement of interest rates, but also the shape and slope of the yield curve and the widening or narrowing of spreads between different benchmarks, to name just a few.

Interest Rate Futures introduced on 31st August, 2009 in INDIA: The National Stock Exchange (NSE) which launched interest rate futures (IRF) on Monday registered a trade volume of Rs 267.31 crore on Day 1, the NSE said in a statement in Mumbai.

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Trading in interest rate futures was earlier inaugurated by Finance Secretary Ashok Chawla, in the presence of SEBI Chairman C B Bhave and RBI Deputy Governor, Shyamala Gopinath. Interest rate futures on NSE are based on a notional ten year GOI bond, bearing a notional 7 per cent interest rate coupon payable half-yearly. The tradable lot size is Rs 2 lakh. Market participants responded enthusiastically to the product launch on the first day. In around five hours of trading time available after inauguration, 1,475 trades were recorded resulting in 14,559 contracts being traded at a total value of Rs 267.31 crore, the NSE said. Out of the two quarterly contracts available for trading, December 2009 was the most active with 13,789 contracts being traded. The bid-ask spread was observed to be around one tick i.e. quarter paisa most of the time, it said. Nearly 638 members have registered for these new products out of which 21 are banks. The contribution by banks in the total gross volume was 32.48 per cent. Amongst banks, Union Bank of India was most active bank. State Bank of India was the first PSU bank to trade, while Central Bank of India has executed the single largest trade. In the domestic private bank category, HDFC Bank executed the first trade. Bank of America, IDBI Bank and Axis Bank also actively participated, the NSE said. "After launching currency futures last year and interest rate futures today, we want to see how to introduce more and more products on the exchange traded platform and settled through central clearing entity which gives settlement guarantee," Securities and Exchange Board of India (SEBI) Chiarman, C B Bhave, said after the launch of interest rate futures in Mumbai. Finance Secretary, Ashok Chawla, said that volumes were not the only thing. The manner in which the market develops is very important, he said. Banks and FIIs can also participate in interest rate futures within the regulatory framework, Chawla said, adding that this is expected to give a push to this product. 48

Interest rate futures will be useful to those who have a view on the future interest rates and would like to benefit from interest rate movements. It is also expected to help those who have large a portfolio of GoI securities and would like to hedge against losses from interest rate movements, the NSE said. Banks, primary dealers, mutual funds, insurance companies, corporate houses, financial institutions and member-brokers will be eligible to participate in IRF trading on the exchange. The members registered with SEBI for trading in currency/equity derivatives segments are eligible to trade in interest rate derivatives, subject to the trading/clearing member having a net worth of Rs 1 crore and Rs 10 crore, respectively. Interest rate futures are the most widely-traded derivatives instrument in the world and it also has a huge opportunity in India. Interest rate risk is the uncertainty in the movement of interest rates which have never been constant in the past and presumably not remain constant in the future as well. The volatility of interest rates has increased manifold in the last couple of years. The annualized volatility of yield of 10-year benchmark Government of India Securities for the calendar year 2008 has been 17.40 per cent compared to 8.51 per cent in 2007.

Turnover of Interest Rate Futures from 31st August to 10th September 10, 2009: Trade Date 10th Sept. 2009 9th Sept. 2009 8th Sept. 2009 7th Sept. 2009 4th Sept. 2009 3rd Sept. 2009 2nd Sept 2009 1st Sept. 2009 31st Aug. 2009 No. of Contracts 3439 2302 4351 8362 5145 3213 6151 8054 14559 Value(in lakhs) 6329.89 4245.67 8017.07 15427.62 9444.85 5890.31 11320.72 14782.11 26731.13

(SOURCE: NSE, http://nseindia.com/interestratefutures/hometop.htm#)

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CONCLUSION:
• In the current scenario, investing in stock markets is a major challenge ever for

professionals. Derivatives acts as a major tool for reducing the risk involved in investing in stock markets for getting the best results out of it. • Awareness about the various uses of derivatives can help investors to reduce risk and increase profits. Though the stock market is subjected to high risk, by using derivatives the loss can be minimized to an extent. • During 1995-2001, when derivatives were not introduced, turnover of cash market was 7853439.4 (Rs. In crores).

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But when Derivatives introduced, its total turnover till August 2009 was (INDEX

FUTURES) 14553850 (Rs. In crores), STOCK FUTURES 23036102 (Rs. In crores), INDEX OPTIONS 9201708 (Rs. In crores), STOCK OPTIONS 1661010 (Rs. In crores). • • • • • So, stock futures are the highest traded derivatives till today. After introduced Derivatives, total turnover of cash market is 7071414.5 (Rs. In crores) In comparison of cash market (15778844 Rs. In crores), derivatives (48452670 Rs. In There is a constant growth in derivatives started from Index futures to interest rate The Indian equity derivatives market has registered an "explosive growth" and is

till 2005-06, which is lesser than before introduction of derivatives. crores.) have 3 times more turnover. futures which was introduced recently. expected to continue its dream run in the years to come with the various pieces that are crucial for the market's growth slowly falling in place.

BIBILIOGRAPHY: References:
Books: • N.D. Vohra & B.R. Bagri, “ Futures & Options ”, Tata McGraw Hill

URLs: • http://nseindia.com/interestratefutures/hometop.htm#

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• • • • • • • • •

http:// nseindia.com/ Home > F&O > Market Information > Historical Data > Business Growth in Derivatives segment http://nseindia.com/Home > Equities > Market Information > Historical Data > Business Growth in CM Segment www.financialexpress.com/.../interest-rate-futures.../496219/ www.investopedia.com/terms/s/swap.asp www.financialexpress.com/.../derivatives-contract-size.../89678/ www.topnews.in/bse-launch-mini-derivative-contract-1st-july-2009-210252 www.scribd.com/doc.../a study- of -how -derivatives -progressing -in –India www.scribd.com/doc/17520479/derivatives-in-india http://www.bseindia.com/about/st_key/volumeofturnoverbusiness_tran_05.asp

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